Liquid Funds 101: Everything you need to know about Liquid Funds

Liquid funds are often used to create one’s emergency fund. It is a wonderful tool for short-term investments. They are used to create a corpus for short-term goals like holidays, annual insurance payment, child’s school fee instalments, etc. which require a specific amount of money at a specific point of time and is not a very significant amount. Even emergency corpus for unplanned medical expenditure etc. can be kept in liquid funds. Corporates use liquid funds for parking their short-term funds as well.

However, before investing in the same, it makes sense to know everything about Liquid Funds and its taxation and take an informed decision!

What are Liquid Funds?

Liquid Funds are funds that invest in the short-term debt and money market bonds that are very different from the equity or equity-related stocks. The tenure of these funds generally ranges from 1 day to 90 days. These funds generally invest in the Term Deposits, Treasury Bills, Commercial Papers, Call Money Option, CDs which are the Certificate of Deposits, and so on. These instruments provide a return that can be categorized as low-risk returns.

These types of funds thus also bring forward another type of advantage and that is the option to get the accessibility to such debt securities which otherwise would have been got only against a good amount of investment as at times few such bonds cost a little too high and is beyond reach for many customers or may not have been acquired as its capture of a greater proportion in a customer’s portfolio does hamper the ratio of diversification.

The actual meaning of Liquid Fund as per the meaning of its name is to provide high liquidity and that is done by these funds. The liquidity is thus available because the investors’ money is so lent out to reputed and creditworthy borrowers that the funds are got back within a certain tenure of lending out with the required interest.

The risk of investing in Liquid Funds:

The danger of credit default risk is very rare as the fund invests in a variety of such bonds where the borrower’s creditworthiness is really high. Even, the change in the interest rate changes the return in the bonds and subsequently the return in the Liquid Fund, as it is clear that the interest rate and the return in the fund would be moving in an inverse ratio. This means that when the interest rate in the bond increases the return of the fund decreases, and it remains constant when the rate of interest remains constant.

This relationship between the yield from the lent out fund and the interest of the Liquid Fund also proves the perfection of the name of this fund as the higher the tenure of the loan given out the lower would be the interest charged and the lower the interest charged, the lower would be the return percentage. Thus it is actually advisable to use this fund as a short term debt fund which generally yields a better return than any other investment type that can be so easily liquidated.

How liquid are Liquid Funds?

The procedure for redemption of a Liquid Fund is very simple and the Fund Management Company when receives a request for liquidation is to credit the account of a customer with the redeemed value by the first half of the following nest day. However SEBI has come up with a new regulation that a customer’s account should be credited instantly after receiving the redemption request up to an amount of Rs 50,000/-, and few Asset Management Companied has already started following the same rule.

The investment options available in the market that can be so easily liquidated are the ones that are the age-old traditional types and the return percentages are too low to beat even the inflation. Such types can be the regular saving account where returns are as low as 3% to 4% where a customer can withdraw his funds any moment and is thus not of much use to gain any extra amount from any surplus funds that are available in the hands of the customer.

Liquid Fund proves to be the most lucrative and an apt option for an investor who wants to park his surplus amount for a given number of days, that is generally less than 3 months, and gain a return out of his investment that is quite high than any of the instruments that guarantee return and liquidity at the same time. This does not mean that investments in Liquid Funds are risk-free. Any investment in any category of the mutual fund always runs the risk of loss and capital erosion and no one can say that the returns are guaranteed but the sort of bonds and investment type determines the factor of the proportion of risk. And in such liquid funds where the invested funds are given out as loans to reputed borrowers whose creditworthiness is really high in the market the risk of capital erosion automatically comes down to negligible and returns got are also of a considerable amount.

Let us understand with an example:

Taking for example in the Aditya Birla Sun Life Liquid Fund, and the HDFC Liquid Fund, which are the funds with a good track record as far as returns and risk are considered, we can clearly see that the investment is mainly done in Debt Bonds which are AAA rated. There is only a low percentage of the investment which is allocated in unrated bonds. Such similar example can also be seen in the L & T Liquid Fund where the investment is done in bonds of the companies which are the top-notch companies in their respective industries and thus the return from the allocated funds are such that it leads to a generalized stable return where even the NAV does not fluctuate much, and capital protection and return percentage is not a factor that needs to be quite a point of worried.

Best Liquid Funds

1. Aditya Birla Sun Life Liquid Fund – Direct (G)
2. Hdfc Liquid Fund – Direct (G)
3. L&T Liquid Fund – Direct (G)

Liquid Funds- a good STP Route

The investment in Liquid Fund can also prove to be a good base for an STP (Systematic Transfer Plan) as a customer might park the fund in a Liquid Fund and from there every month would be deducted a certain amount which would be then allocated in the Equity Funds. This is one perfect way to reduce the risk of volatility of an equity market and the effects it can have on a one-time lump sum investment.

In a nutshell

Therefore the overall view of a Liquid Fund is such that it can be considered as one of the best funds where a surplus amount can be parked for a certain amount of time and a return more than that got from the similar traditional instruments can be got with hardly any risk as compared to the equity market. And though there would be an Expense Ratio that a customer would need to bear in the form of a charge still it is a way more profitable instrument. The Liquid Funds can also be beneficial to provide tax-free returns if the investment is continued for more than 3 years but in that case, the returns would be hampered. Thus the general suggestion while investing in a Liquid Fund would be to invest in the fund for a short time and get more return than any type of the traditional investment with similar features could provide.